The cash flow of the "perpetual annuity" is considered an extremely value-sensitive parameter in the DCF valuation. Among other things, it is determined by the level of long-term investments.
Introduction
The following article provides brief and concise information on the relationship between investments and depreciation in the perpetual annuity.
The cash flow of the "perpetual annuity" is considered an extremely value-sensitive parameter in the DCF valuation. Among other things, it is determined by the level of long-term investments. Depreciation has a secondary effect: although it is initially non-cash, a valuation-relevant cash effect arises via the tax relief.
Investments and depreciation: A common mistake
Investments and depreciation are often recognized in the same amount in perpetuity. This is generally incorrect. The easily understandable reason for this is that investments are made at current procurement costs, while depreciation reflects historical costs. Both cost variables are not identical for price increase rates > 0.
A rule of thumb for the difference between investments and depreciation is: depreciation period / 2 * price increase. For assets with a useful life of 20 years and an average price increase of 2 % p.a., investments are therefore ~ 20 % higher than depreciation. This applies in principle always and not only for the "perpetual annuity".
For valuers, knowledge of this effect is important because the financial planning is usually provided by the client and/or the management, whereas the determination of the perpetuity is the original task of the valuer. Neglecting this effect leads to an overvaluation due to overestimated depreciation and the resulting tax relief.
Key message
Investments should reflect replacement costs, whereas depreciation should reflect historical costs. Typical error: Investments and depreciation are recognized in the same amount.
The difference between capital expenditure and depreciation is a critical factor in DCF valuation, especially in perpetuity. Taking into account current acquisition costs for capital expenditure and historical costs for depreciation ensures a realistic and accurate valuation. smartZebra's tools and expertise can help to carry out these complex valuation processes efficiently and accurately.
We support you in researching the data — e.g. putting together the peer group — with a short training session on how to use the platform. We are happy to do this based on your specific project.
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